The Fed Gets Marked to Market

By

Randall W. Forsyth

March 18, 2015

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Actions speak louder than words.

While the Federal Open Market Committee made the nearly universally expected excision of the word “patient” to describe its intentions to raise interest rates, it racheted down its projections for the federal funds rate sharply.

Specifically, the FOMC’s famous — or notorious, depending on your view — “dot plot” of the policy-setting panel’s projections of the federal funds rate was lowered substantially to closer to what the fed-funds futures market has been saying all along. That is, the Federal Reserve’s rate target will remain lower for longer than the central bank’s officials had been forecasting.

The effect on the markets Wednesday was electric. Stocks rallied, with the Dow Jones Industrial Average surging 224 points, or 1.26%, back over the 18,000 mark. That was the best of the major gauges, with the Standard & Poor’s up about the same but the Nasdaq and the Russell 2000 up less than 1%.

The real action was in the bond market, where prices staged a massive rally as yields moved down sharply across the Treasury yield curve. In effect, the backup in the bond market over the past month was reversed. The result: The 30-year bond yield saw its sharpest drop in nearly a year.

As a result, the popular iShares 20+ Year Treasury Bond exchange-traded fund (ticker:
TLT
) soared nearly 2% in price — roughly the same as a 350-point pop in the Dow. And for those who want to swing for the fences in terms of bull bets on the long end of the Treasury market, the Vanguard Extended Duration Treasury ETF (
EDV
) was up 2.8% — equivalent to a 500-point Dow-palooza.

The international ramifications of the Fed’s actions were just as dramatic, with the dollar sliding sharply.

The greenback previously had soared to the highest levels in more than a decade on expectations the U.S. central bank would commence hiking rates at midyear while its counterparts abroad were aggressively easing monetary policies.

The FOMC statement did not explicitly mention exchange rates, but Fed Chair Janet Yellen acknowledged the impact of the strong dollar along with the drop in energy prices in keeping inflation under the central bank’s 2% target in her post-meeting press conference.

Yellen also commented in the press conference that the Fed realizes its policies have an effect on the rest of the world. That acknowledgment followed the warning the prior day from International Monetary Fund Managing Director Christine Lagarde of financial market volatility from tighter U.S. monetary policy that “could give rise to potential stability risks.”

And, as if to underline the dramatic divergence of the course of Fed policies from other central banks, Sweden’s Riksbank lowered its repurchase rate to negative 0.25% from negative 0.10%. The world’s oldest central bank commented, “there are signs that inflation has bottomed out and is beginning to rise, but the recent appreciation of the krona risks breaking the trend.” In other words, the risk remains in the direction of deflation.

For those who don’t believe in coincidences, the timing of the Riksbank move ahead of the FOMC decision ought to raise eyebrows. Could it have been a signal to the Fed or just a random event? You make the call.

Yellen’s acknowledgment of international factors also follows comments last week by Bank of England Governor Mark Carney, who noted sterling’s strength could pressure U.K. inflation lower, implying rate hikes there could be staved off further. The Fed and the BOE have been expected to be the first major central banks to raise interest rates.

The reality that the Fed would be slower to raise rates was expressed in the FOMC’s dot plot graph of committee members’ guesses on where the funds target would be at the end of 2015 and 2016. The median projection for year-end was the midpoint between 0.5% and 0.75% — a hefty half-percentage-point lower than the previous forecast made last December. And the plot showed a drop to the midpoint between 1.75% and 2% for the end of 2016, down significantly from 2.50% previously.

For its part, December fed-funds futures were pricing in a rate of 0.41%, down a significant 10.5 basis points (0.105 percentage points) from Tuesday’s settlement. While the futures market still remains below the Fed’s forecast, the FOMC Wednesday closed the gap significantly.

Those lowered rate projections were the result of the reduced forecasts for growth in gross domestic product and inflation — as well for the unemployment rate. The lower jobless rate might be associated with greater slack in the labor market than previously thought, Yellen observed. In any case, it’s an acknowledgment that the drop in the unemployment rate hasn’t produced the wage or income gains the Fed has been seeking.

All of which brings the Fed more in tune with reality. The bond market was spooked into believing the rhetoric of Fed watchers and some officials. But the fed-funds futures market continued to chart a more moderate path of future rate hikes.

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